BI > FEBRUARY 2005

Small Holdings -- Time-Wasters?

Midland Jayvestors

Midland Jayvestors goes a long way back. The club started 44 years ago and counts nine founding members among the present 16. The original members decided on their interesting name because they belonged to the local Junior Chamber of Commerce (Jaycee) chapter.

While the club enjoys around $200,000 in holdings, its portfolio was much larger when the 1990s bull market was in full swing. At the end of 1999 the portfolio reached a peak of $560,500. Distributions to departing members played a part in the rollback, but so did depreciation in the value of the portfolio.

Midland Jayvestors. Clockwise, from left: Stu Bender, Don Beckwith, Bob Nankee, Max Bottomley, Al Gunkler, Gus Constan, Bill Kennett, Fred Hoerger, Jack McKelvey and Bob Hansen. Not pictured: Gary Allen, Dale Ducommun, Stan Englund, Ted Ilgenfritz, Pete Lehman and Bill Marklewitz.

Members admit they strayed from NAIC principles in the 1990s. Certainly many clubs were tempted by the easy money that others were making without adhering to any specific investment discipline. Unlike many clubs, however, Jayvestors has returned to its NAIC roots, with several members taking NAIC classes to sharpen their skills.

Part of the motivation for returning to NAIC methods was competition with other local investment clubs. In these contests, the winners tended to be women's clubs that adhered to NAIC principles. I can't fault the logic of using what works, and it certainly took courage to admit that changing course back to the NAIC system was in order.

About three-quarters of the 16 members have introduced stocks that are currently in the portfolio. Even the members who don't present stocks participate by doing record-keeping and handling other necessities. This is a tremendous participation rate, and the members are to be congratulated.

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Mastery of Diversification

Members have mastered an important investing principle -- being diversified. Their portfolio contains 23 stocks, which would seem to provide some insulation from any shock that might affect one holding. The portfolio also has significant representation from companies in major economic sectors such as consumer (31.5 percent of the portfolio), medical (26.2 percent) and finance (15.5 percent).

True diversification comes not just from having a certain number of stocks in the portfolio but also from investment in enough industries. A 20-stock portfolio isn't diversified if 10 are technology companies or retailers, for example.

Portfolio management becomes more difficult as the portfolio grows larger. The club's six smallest holdings total less than the single largest holding -- The Home Depot, Inc. -- 9.4 percent of the portfolio. These holdings are so small they hardly even qualify as investments. They should be evaluated and built up or sold.

Of the six, two are blue chips (General Electric Company and Intel Corporation) about which much information is available. One question is how much growth is left in such large companies.

The strategy of GE's new CEO, Jeffrey Immelt, seems to be one of growth through acquisition. Considering GE's size and dominance in several markets, this may be the best avenue for growth. Given its trailing 12-month price-earnings ratio of 24, however, investors pay dearly for a company that's grown just 2 percent annually for the past two years.

Two others are well-established companies that appear to be struggling to make it to the next level -- Forest Laboratories, Inc., and Kohl's Corporation. Forest has produced tremendous growth over the past five years, with earnings per share growing at a compound annual rate of 51 percent. A company with this kind of growth and a 12-month trailing P/E ratio of just 16 may warrant some research.

Forest acquires and develops small pharmaceutical products. One, the antidepressant Celexa, turned into a blockbuster. As Forest prepares for the generic competition Celexa will face in early 2005, it has urged doctors and patients to use its next-generation antidepressant Lexapro.

The risk with Forest is that 76 percent of its third-quarter revenue came from Celexa and Lexapro. The company recently reduced its earnings forecast based on generic competition for Celexa. Jayvestors bought Forest near an all-time high and then watched it tumble 60 percent. Even so, the club may want to consider adding to the position if some of the company's new products become more promising.

Kohl's is a fine retailer and a company I've admired for many years. Growth has slowed, as it seems to be caught between discounters like Wal-Mart Stores, Inc., and fancy luxury retailers with fat margins and products that consumers aspire to own.

The remaining small holdings are KVH Industries, Inc., and Pro-Pharmaceuticals, Inc., very small companies struggling to achieve profitability. Two of the three biggest percentage losses sustained by Jayvestors occurred in these money-losing companies.

Companies like these aren't consistent with NAIC methods, and investors should be very hesitant to tackle them. The club bought the stocks because one member believed the companies would have strong futures based on potential new products and therefore might be fun to watch.

The problem with very small holdings is the amount of time investors can spend tending stocks that are financially insignificant to them. I've just committed this sin by treating these tiny holdings as if they can affect the club's results in a meaningful way.

Below the Blue Chips

One reason the Jayvestors portfolio attracted my attention was its diversification into medium-sized and smaller companies. That's one of the things the club has done extremely well.

While blue chips should form the core of most portfolios, it's necessary to hold shares of smaller companies to prevent portfolios from growing stale. Small and medium-sized companies also enhance diversification, since not all types of stocks go up and down in tandem. These companies also tend to have higher potential growth than do the big blue chips.

Among the club's biggest winners are Cisco Systems, Inc., and Home Depot, two blue chip growth companies purchased in the mid-1990s. Another big winner is mid-cap First Health Group Corp. Small-cap Bright Horizons Family Solutions, Inc., is up 41 percent since the club bought it in 2003.

Despite strong results in the early 1990s, First Health Group has sometimes struggled, often using acquisitions to fuel growth. Business became tougher in 2004, and the company recently agreed to be acquired by Coventry Health Care, Inc. Coventry runs health insurance plans. The company has grown strongly and trades at a very reasonable P/E.

Bright Horizons Family Solutions provides child care through centers located at parents' workplaces. It operates about 555 centers for 400 clients and cares for 61,500 children. The club paid a P/E of close to 30 for this strong growth company, and the decision has paid off well. There are higher risks with companies like this, but they can add a new dimension to a portfolio.

The club has also enjoyed considerable success with dental and medical products distributor Henry Schein, Inc., another mid-cap stock. This one has risen 63 percent in the 2 1/2 years the club has owned it. The P/E still seems reasonable, as earnings have grown strongly.

Despite being subject to the ups and downs of the property and casualty insurance industry, HCC Insurance Holdings, Inc., has earned an underwriting profit in seven of the past 10 years. That means this small company is earning more in premiums than its expenses and insured losses.

While this might seem to be the only way to succeed in this industry, most companies have lost money on insurance and made up for it with earnings on their investment portfolios. HCC took a hit from the hurricanes this year but still seems to be a company worth watching.

The presence of these companies gives the portfolio more growth potential than an all-blue-chip portfolio. The core of the portfolio does, however, remain blue chip-oriented with solid low- to mid-teens growth potential from well-known companies such as Biomet, Inc., Federal Home Loan Mortgage Corporation (Freddie Mac), Home Depot, Lowe's Companies, Inc., MBNA Corporation, Pfizer Inc. and Walgreen Co.

Common Challenges

There are two areas in which the club has struggled somewhat. Both are common challenges for clubs. One is what to do when longtime holdings start to experience moderating growth. Home Depot is certainly not the grower that it used to be, although it experienced a resurgence in 2004 after a few moderate years. Cisco has also probably seen its best growth years already.

The most aggressive investors might sell and move on. A more practical approach for most investors is to use these aging giants as a source of cash to buy stocks that seem more appealing today. It isn't disloyal to sell off pieces of a company that has been a good investment, but it's important to sell because the outlook is unexciting, not just because the stock has appreciated. Selective pruning is necessary to keep a portfolio from growing stale.

The second challenge for the club is a lack of new stock ideas. About half the holdings have been owned more than 18 months. Many of these were purchased when the market was low in 2002 and 2003. Only one -- Pfizer -- is currently below cost.

Of the 11 remaining stocks that are less than 18 months old, four are winners and seven have current prices that are below the club's cost. Six of these have been very costly, with losses of 21 percent to 65 percent. We've already discussed four of them (Forest Labs, Intel, KVH Industries and Pro-Pharmaceuticals).

Cardinal Health, Inc., is one of the other two decliners, with a loss of 21 percent from cost. I own Cardinal Health and believe it to be the best-positioned company in a vital industry. About 40 percent of its business consists of drug distribution, and this part of the business has gone through tremendous change, particularly in 2004.

Cardinal and its competitors used to benefit when drug manufacturers raised prices and the distributors sold inventory at a profit. In fact, Cardinal used to acquire much more inventory just before the price hikes went into effect. The erratic nature of these purchases added to the cost structure of the pharmaceutical manufacturers, which have recently moved toward using just-in-time inventory systems.

The drug distributors are negotiating for service fees to replace the inventory-holding profits. While the outcome of these negotiations is uncertain, three big distributors handle most of the volume -- and high-margin drug manufacturers do need a way to get product to the market.

The other stock purchased recently -- another one in which the club is losing money -- is Dollar Tree Stores, Inc. Dollar stores are very easy to open and operate, so competition is everywhere. Growth has slowed over the past five years as have margins and return on capital. At a trailing 12-month P/E of 18, this is a candidate for acquisition.

Tend to What You Already Own

Every investor runs into a little trouble from time to time. We all need to keep challenging our existing holdings to ensure they're still stocks we would buy if the decision were being made today.

It's easy to ignore problem stocks when the focus is just on buying. Club investors often fall in love with new ideas and shun the elimination of problem stocks or the addition of money to existing holdings.

The number of holdings can rise to unmanageable levels, and the Jayvestors portfolio is close to that point. Most clubs should stop buying when the list of holdings gets to 20 or so. From then on, members should use the Challenge Tree and Portfolio Evaluation Review Technique (PERT) to compare new prospects with existing holdings.

There was an eight-month span during which the club purchased new holdings in six of the months. Finding an undervalued growth company is one of the most exciting things about investing, but good portfolio management necessitates watching the other side, too.

Keep the portfolio fresh, but don't ignore the possibility of adding to existing holdings. This approach may sound less thrilling than buying new stocks, but don't just collect stocks -- manage the portfolio.

The opinions expressed in this article are those of the author and do not necessarily reflect positions of either Better Investing or NAIC. Portfolios are reviewed only in "Repair Shop." Send portfolio, current valuation statement and description of club challenges to "Repair Shop," c/o NAIC, 711 W. 13 Mile Rd., Madison Heights, MI 48071.

If a sharp photograph is available, send it along with the members' names, in order, and preferably in the form of a JPEG (RGB) electronic image set up as a high-resolution (300 dpi) or large (72 dpi) file. Include names of those not pictured.

Scott D. Horsburgh, Chartered Financial Analyst, is president of the investment management firm Seger-Elvekrog Inc., Bloomfield Hills, Mich. The author and clients of his business may own stocks mentioned in this article. Views expressed in this feature are those of the author and don't necessarily reflect positions of either this magazine or BetterInvesting. No investment recommendations are intended.